AQA A-level Economics: Financial markets, financial assets, money and bonds (7136)

This guide follows the AQA AS and A-level Economics specification (version 1.3, 29 June 2022). It covers one A-level sub-section: The structure of financial markets and financial assets. The combined PDF numbers it 4.2.4.1; the AQA website and site map number it 3.2.4.1, under Financial markets and monetary policy. Commercial and investment banks, credit creation, financial regulation, central banks and monetary policy are separate sub-sections and are not repeated here. All countries, firms and numbers below are made up for illustration. Recall the essentials with the revision notes, then attempt the practice questions. The hub is AQA A-level Economics, the printable checklist tracks progress, and the free 10-minute diagnostics point you to weak areas.

Coverage

Specification point	What you need to do
Money	State its characteristics and functions
Money supply	Define it and distinguish narrow money from broad money
Three markets	Distinguish the money market, the capital market and the foreign exchange market
Financial markets	Explain their role in the wider economy
Debt and equity	Explain the difference
Raising finance	Know shares, corporate bonds and bank borrowing as ways firms raise finance
Government bonds	Use the terms coupon and maturity; calculate a yield
Bond prices	Explain why market interest rates and bond prices move in opposite directions

Money: characteristics and functions

Money is anything that people generally accept when buying goods and services or paying off what they owe. Without it, trade needs barter, which requires a double coincidence of wants: the baker must find someone who has flour and wants bread at the same moment. Barter also gives no common measure of value and no easy way to save.

Money works only if it has these characteristics:

• Acceptability. Everyone will take it.
• Durability. It survives repeated use.
• Portability. It is easy to carry and transfer.
• Divisibility. It can match prices large and small.
• Uniformity. One unit is the same as another.
• Limited supply. If anyone could create it freely it would lose value.
• Stable value. It buys roughly the same tomorrow as today.

Its functions are:

1. Medium of exchange. People accept it for goods, so no double coincidence of wants is needed.
2. Store of value. Purchasing power can be held until later. Inflation weakens this function.
3. Unit of account. Every good has a price in one measure, so comparing values is easy.
4. Standard of deferred payment. Debts and contracts can be fixed in money terms. Again, high inflation damages this.

Link functions to characteristics when you write: a seashell fails on uniformity and limited supply; a stone is not portable.

The money supply: narrow and broad money

The money supply is the total amount of money held in an economy at a given moment. Definitions differ between countries and over time, so use the definition a question gives. The distinction is about liquidity, the ease and speed of turning an asset into spendable money without loss of value.

• Narrow money covers the assets that can be spent immediately: notes and coins in public hands and, in many definitions, banks’ own balances at the central bank.
• Broad money is narrow money plus other deposits in banks and building societies, including savings accounts that need notice, and in some definitions other liquid assets. Some of these must be switched or given notice before use.

Narrow money is therefore a subset of broad money.

Worked example 1: measuring money in Country A

Country A defines narrow money as notes and coins held outside banks. Broad money is narrow money plus all bank deposits. Figures (billions of units, illustrative): notes and coins 36; instant-access deposits 164; notice accounts 230; fixed-term deposits 170.

• Broad money = 36 + 164 + 230 + 170 = 600.
• Narrow money as a share of broad = 36 ÷ 600 × 100 = 6.0%.
• Households withdraw 10 from instant-access deposits as cash. Narrow money rises to 46. Deposits fall by 10, so broad money = 46 + 154 + 230 + 170 = 600, unchanged.
• Households move 30 from a notice account to an instant-access account. Neither measure changes, but broad money is now more liquid.

Three financial markets

	Money market	Capital market	Foreign exchange market
What is traded	Short-term loans and assets, usually maturing within a year	Long-term finance: shares and bonds	Currencies
Examples	Lending between banks; government treasury bills; short-term commercial paper	Shares; corporate and government bonds	Buying one currency with another
Main purpose	Managing day-to-day liquidity and short-term funding	Funding long-term investment and government spending	Trade and investment across currencies
Price	Short-term interest rates	Share prices; bond prices and yields	Exchange rates

Within the capital market, a primary market is where new shares or bonds are first sold, raising money for the issuer. A secondary market is where existing ones are traded between investors. Secondary markets raise no new funds for the issuer but make assets liquid.

The role of financial markets in the wider economy

Financial markets connect those with surplus funds (savers) with those who need funds (firms, households, governments). Their roles are:

• Channelling savings into investment. Savers want returns and liquidity; borrowers want large, long-term funds. Markets bridge the gap.
• Providing liquidity. A saver can sell a bond or share in the secondary market, so lending for the long term feels safe.
• Price signals. Interest rates, bond yields and share prices show where funds are most valued, steering finance toward expected high-return uses.
• Spreading and pricing risk. Investors can hold a spread of assets, and firms can reduce exposure to changes in currency or interest rates.
• Supporting international trade and investment. The foreign exchange market lets payments cross currencies.
• Funding government. The bond market lets government borrow to cover a deficit.

Chain of reasoning. Well-functioning markets lower the cost of finance → more projects have an expected return above the cost of funds → investment rises → capital stock and productive capacity grow → aggregate demand rises now and long-run aggregate supply rises later.

Evaluation. Markets can misprice assets. Herd behaviour, speculation and poor information can inflate asset prices and cause sharp falls, which damage confidence and can spread through the economy. Small firms often face higher borrowing costs or are shut out. The benefits also depend on regulation, covered in a different unit.

Debt and equity

Debt is borrowed money that must be repaid, normally with interest. Lenders are creditors and gain no ownership. Equity is money from owners: buying shares gives part-ownership, a claim on profits through dividends, and usually voting rights.

	Debt	Equity
Return	Interest, a fixed legal obligation	Dividends, which the firm may reduce or skip
Repayment	Principal repaid at maturity	No repayment; shares can be sold to others
Control	Lenders have no say unless the firm defaults	Shareholders vote and share control
Risk to firm	Higher: payments are due even in a downturn	Lower: no fixed payments
If firm fails	Creditors are paid before shareholders	Shareholders paid last, may get nothing

Ways firms raise finance

• Issuing shares. New owners provide funds. No repayment, but existing owners’ share of control and profit is diluted.
• Issuing corporate bonds. The firm borrows from many investors, paying a coupon and repaying the nominal value at maturity. Bonds can be traded.
• Borrowing from a bank. Quicker and more flexible, often with security required. Not usually tradable.

Worked example 2: loan or new shares?

A small bakery chain has 100,000 shares and profit before interest of 90,000. It needs 600,000 for new ovens. The bank offers a loan at 7%. Alternatively it can issue 60,000 new shares at 10 each.

• Annual interest on the loan = 600,000 × 7% = 42,000.
• Shares after an issue = 100,000 + 60,000 = 160,000.
• Good scenario. The ovens add 60,000, so profit before interest = 150,000.
  • Loan: (150,000 − 42,000) ÷ 100,000 = 1.08 per share.
  • Shares: 150,000 ÷ 160,000 = 0.9375 per share.
• Downturn scenario. Profit before interest falls to 40,000.
  • Loan: (40,000 − 42,000) ÷ 100,000 = −0.02, a loss.
  • Shares: 40,000 ÷ 160,000 = 0.25 per share.
  • Interest cover (profit ÷ interest) falls from 150,000 ÷ 42,000 = 3.57 to 40,000 ÷ 42,000 = 0.95.

Judgement. Debt magnifies gains when returns are good and losses when they are poor. It suits stable, predictable profits. Equity suits uncertain profits and high-growth firms, but dilutes control. The answer depends on the stability of profit, existing borrowing and interest rates.

Government bonds: coupon, maturity and yield

A government bond is a loan to government, usually from many investors. Key terms:

• Nominal (face) value. The amount repaid at maturity. Prices are quoted per 100 of nominal value.
• Coupon. The fixed annual payment, stated as a percentage of nominal value.
• Maturity. The date when the nominal value is repaid, or the time remaining until then.
• Market price. What the bond sells for in the secondary market. It can be above or below nominal value.

Yield (current yield) = annual coupon payment ÷ market price × 100.

Worked example 3: calculating yields

Country A issues a bond with nominal value 100 and a coupon of 5. Maturity is 10 years.

• Price 100: 5 ÷ 100 × 100 = 5.00%.
• Price 80: 5 ÷ 80 × 100 = 6.25%.
• Price 125: 5 ÷ 125 × 100 = 4.00%.

The coupon stays at 5 in every case. Only the price changes, so the yield changes.

Why interest rates and bond prices move inversely

The coupon is fixed when the bond is issued. If market interest rates rise, newly issued bonds pay higher coupons. Nobody pays 100 for a bond paying 5 when 100 buys a new one paying 8. Demand for the old bond falls and its price falls until its yield matches the market rate. If rates fall, the old coupon looks generous, demand rises and the price rises.

Worked example 4: price when rates change

Take an irredeemable bond (no maturity date) with coupon 5. Price = coupon ÷ required yield.

Market interest rate	Price per 100 nominal
4%	5 ÷ 0.04 = 125.00
5%	5 ÷ 0.05 = 100.00
6.25%	5 ÷ 0.0625 = 80.00
8%	5 ÷ 0.08 = 62.50

A rise from 5% to 8% cuts the price from 100 to 62.50, a fall of 37.5%.

Maturity matters. For a bond with a maturity date, the holder also receives the nominal value on that date, so the price falls less. Take a bond with coupon 6 and market rates rising from 6% to 8%. A bond with 1 year left falls to about 98.15; one with 5 years left to about 92.01; an irredeemable bond to 75. The longer the time to maturity, the larger the price fall.

Who is affected.

• A holder who sells before maturity suffers a capital loss.
• A holder who keeps the bond to maturity still gets the nominal value and the coupons.
• Government faces higher yields on new borrowing, which raises the cost of financing debt.
• Investors who expect rates to rise may sell now, bringing the price fall forward.

Common errors

• Describing money as “income”. Money is a stock of liquid assets.
• Putting savings deposits in narrow money without checking the definition given.
• Stating that the coupon changes when the price changes. The coupon is fixed.
• Calculating yield as coupon ÷ nominal value when the question gives a market price.
• Confusing the money market with the capital market. The line is the length of time the money is lent, not the size.
• Saying that shares must be repaid, or that debt gives ownership.
• Explaining the inverse relationship without mentioning the fixed coupon and the alternative return on new bonds.

Official syllabus

AQA AS and A-level Economics specification, version 1.3 (29 June 2022), published by AQA: A-level content, The structure of financial markets and financial assets (4.2.4.1 in the combined PDF; 3.2.4.1 on the AQA website), within Financial markets and monetary policy.